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July 6, 2011

Firm News for July 2011: Best Practices: EPCs and Oil and Gas Leases

By: Joseph A. Ernst, Esq.

Under the Eligible Passive Company Rule in the SOP 50 10 5(C), in the event that an Eligible Passive Company (“EPC”) becomes the beneficiary or owner of the rights to an existing mineral lease on the property that the EPC acquires, the EPC must assign its interest in the mineral lease to the Operating Company (“OC”). One would think that it would be easy to determine if there is such an existing mineral lease through a search of the chain of title. However, this is often not the case due to the unique nature of oil and gas leases, which are unlike other leases that lenders typically have to deal with. Because the SOP expressly states that the EPC Rule is an exception to SBA regulations that prohibit financing assets that are held for passive income, the EPC Rule is interpreted strictly. Consequently, the failure to identify an existing oil and gas lease on the EPC acquired property and to assign the EPC’s interests in the lease to the OC could jeopardize the SBA guaranty.

Over the last decade there has been much activity in many areas of the United States that have rich natural gas shale reserves. These reserves are referred to as “shale plays,” and there are at least seventeen named shale plays in the United States, the most important of which are the Barnett shale play in northern Texas, the Haynesville shale play in northwestern Louisiana and eastern Texas and the huge Marcellus shale play predominately in Pennsylvania and West Virginia, but also extending into Ohio and New York. In addition to the current natural gas activity in these shale plays, lenders should also keep in mind that during the last quarter of the 19th century through the first quarter of the 20th century certain regions of the country produced natural gas in significant quantities, in large part for use in gas lighting. The oil and gas leases from the 19th and 20th centuries, although decades old, may nevertheless still be in full force and effect for the reasons outlined below.

Oil and gas leases are drafted and are intended to remain effective for an indefinite period of time. The means by which oil & gas leases are preserved or held for decades by oil and gas companies are through:

(i) the production of oil or gas; or

(ii) the payment to the landowners of relatively small sums of money; or

(iii) by merely investigating the property for the development of oil or gas.

The latter means of holding the lease by investigating the property for development is a catch-all means that includes off-site development and marketing efforts, and allows oil and gas companies to claim that a lease is still in force, even if the oil and gas company has not been on the property for years. Therefore, if a lender comes across an oil and gas lease in the chain of title of the EPC acquired property, the lender should not assume that, if the primary term of the lease has expired, that the oil and gas lease is no longer in effect. In fact, the lender should assume that any oil and gas lease (even those from the later part of 19th century and the early part of the 20th century) are still in full force and effect, unless there is a memorandum of lease termination or release of lease in the chain of title.

In addition to requiring that the EPC assign its interest in the oil and gas lease (together with its rights to all rental, mineral, royalty, bonus or similar lease payments) to the OC, the SOP also requires that (i) any such assignment be subordinated to all Mortgages or Deeds of Trust; (ii) if such subordination is not possible, the lender must provide documentation to that effect; (iii) if the mineral lease has been terminated, the lender should attempt to have it removed from the Title Policy; and (iv) if the lender is unable to have the terminated lease removed from the Title Policy, the lender must provide supporting documentation evidencing the proper assignment of the lease to the OC and obtain a title endorsement to protect the SBA’s interest in the real property (i.e., California Land Title Association (“CLTA”) 100.23 or 100.24) (see page 123 of the SOP). CLTA 100.23 protects lenders against loss sustained by reason of damage to existing improvements resulting from the exercise of any right to use the surface of the land for the extraction or development of the minerals leased under the oil and gas lease noted in the Title Policy, and CLTA 100.24 protects lenders against loss or damage sustained by reason of the oil and gas company having the right to enter upon or use the surface of the land under the terms of the oil and gas lease noted in the Title Policy. Similar protection is also afforded by the ALTA 9 endorsement.

In summary, Lenders should be cognizant of shale plays currently in production, being actively developed or being leased-up for future development. Lenders should also be cognizant that decades old oil and gas leases, with a primary term that long ago expired, may nevertheless still be in full force and effect. To ensure compliance with the SOP, any existing mineral lease on the EPC property must be assigned to the OC, subordinated to all Mortgages or Deeds of Trust (if possible) and removed from the Title Policy or endorsed as described above.

For more information on SBA-related mineral lease issues, contact Joseph at: jernst@starfieldsmith.com or (215) 542-7070.